Andrew’s Analysis: Earnings Present A Tougher Target This Quarter

Andrew’s Analysis: Earnings Present A Tougher Target This Quarter

over 3 years ago2 mins

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As third-quarter earnings get underway in the US, analysts have set a higher bar than usual for companies to jump – leaving many at risk of tripping up. With valuations also lofty, the stock market could be doomed to disappoint.

What does this mean?

When companies report results, it doesn’t matter much whether profits rise or fall but rather whether those profits beat or miss analysts’ expectations. Companies understandably want a low hurdle to jump – and most of the time they succeed in persuading analysts to trim their estimates during the course of a quarter.

But something rare happened during the third quarter: FactSet data shows that analysts actually increased their projections – and by more than 4% at that. This was just the fourth quarterly increase in the past decade.

(Source: Factset)
(Source: Factset)

Analysts have given the biggest boosts to four sectors: energy, financials, materials, and consumer discretionary – companies that sell things you want but don’t need, like televisions or cars. And, further clouding the outlook, more than a quarter of companies in the S&P 500 are still not providing guidance on their expected full-year profit thanks to coronavirus.

Why should I care?

Well, on Tuesday we got an early flavor of the disappointments that could be in store, when shares of JPMorgan and Citigroup fell as much as 4% as of midday in New York – despite both banking giants reporting earnings that significantly exceeded analysts’ estimates.

In another sign that some parts of the market might have become overexcited, data from SentimenTrader shows that small investors are once again ramping up their purchases of call options – derivatives that allow you to make leveraged bets on future gains in stock prices. Such speculative behavior was a feature of this summer’s feverish markets, which eventually ended with a sharp pullback in tech stocks.

(Source: SentimenTrader)
(Source: SentimenTrader)

Of course, such pullbacks are hardly surprising when the S&P 500 is trading at such a lofty valuation compared with its expected profits. Check out this chart of the index's price-to-earnings ratio.

(Source: FactSet)
(Source: FactSet)

To be fair, companies have managed quite well so far despite the higher expectations. Of the 22 S&P 500 companies to have reported third-quarter results as of Monday, 91% beat earnings estimates, according to Refinitiv.

Still, the current market situation has certainly sent veteran investor Howard Marks, of Oaktree Capital, into a philosophical mood. In a long report released on Tuesday he lamented the disconnect between potential returns and the prices investors are being forced to pay – thanks to unprecedented stimulus from the Federal Reserve (the Fed).

“When uncertainty is high, asset prices should be low, creating high prospective returns that are compensatory,” he wrote. “But because the Fed has set rates so low, returns are just the opposite. Thus the odds aren’t on the investor’s side, and the market is vulnerable to negative surprises.”

Don’t say you haven’t been warned.

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